July 2023: Inflation watch

July 2023: Inflation watch

In this issue, we discuss the unexpected increase in headline CPI in July and the significant decrease in RRB trading volume.

PM spotlight

Steve Morris, CFA, Senior Managing Director & Portfolio Manager

Steve’s take: “As of July, Canadian headline CPI increased 0.6% month-over-month, exceeding market consensus by 0.3% and bringing the year-over-year increase up to 3.3% (figure 1).”

While a pickup in year-over-year headline inflation was expected based on unfavourable base year effects, the increase was well above consensus with a large contribution from shelter (figure 2). Additionally, the recent rise in gasoline prices was not fully reflected in the July CPI report due to the timing of the sampling, which is expected to put upward pressure on the August CPI print.

Higher interest rates continue to flow through to mortgage interest costs, which increased another 2.0% month-over-month and 30.5% year-over-year.

While grocery prices remain elevated, year-over-year price growth has decelerated (8.5% in July vs. 9.1% in June) mainly due to prices for fresh fruit. 

Figure 1: CPI Change

Figure 1

Figure 2: Canada headline CPI contribution year-over-year

Figure 2

Steve’s take: “Breakeven inflation rates have settled at lower levels despite expectations of higher demand for real return bonds (RRBs), suggesting that investors may be demanding a higher illiquidity discount.”

Following the Government of Canada’s announcement in November 2022 of their decision to cease RRB issuance, breakeven inflation rates experienced an initial spike before stabilizing at slightly lower levels compared to pre-announcement (figure 3). Some market participants may have expected a persistent increase in breakeven inflation rates as a proxy for RRB demand. However, breakeven inflation rates are primarily driven by the combined net effect of two fundamental factors: market expectations for future inflation and liquidity of RRBs. In the event of significant decreases in RRB liquidity, breakeven inflation rates may become a less effective indicator of RRB demand and future inflation expectations.

Comparing the 9-month periods before and after the November 2022 announcement, trading volume of RRBs has decreased by approximately 66% (figure 4). This suggests that demand for RRBs and future inflation expectations may be higher than implied by breakeven inflation rates due to a higher illiquidity discount.

Figure 3: Long-term breakeven inflation rates

Figure 3

Figure 4: Weekly trading volume of on-the-run Canada RRBs (as demonstrated by CA135087M433)

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CPI change (figure 1)

12-month, YTD, and MoM change in the Statistics Canada Consumer Price Index, monthly, not seasonally adjusted (Table 18-10-0004-01)

Canada headline CPI contribution year-over-year (figure 2)

Bank of Canada Consumer Price Index Portal

Long-term breakeven inflation rates (figure 3)

Calculated as ((1 + Government of Canada benchmark bond yields, long term [CANSIM V39056])/(1 + Real return benchmark bond yield, long term [CANSIM V39057])) – 1.

Weekly trading volume of on-the-run Canada RRBs (CA135087M433) (figure 4)


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